Help for auditors in evaluating financial statement misstatements.

Earnings Management and
the Abuse of Materiality

BY C. TERRY GRANT, CHAUNCEY M. DEPREE, JR.,
AND GERRY H. GRANT

ake your pick of fraudulent financial reporting schemes. One of these gimmicks, manipulating reported income through “earnings management” techniques, draws its share of attention in the financial press. A company can effect earnings management practices in a variety of ways. One of the most popular vehicles for earnings management, however, stems from a misuse or misunderstanding of the proper application of materiality, a concept central to the preparation and audit of all financial statements. SEC Staff Accounting Bulletin (SAB) no. 99, Materiality, provides guidance for preparers and independent auditors on evaluating the materiality of misstatements in the financial reporting and auditing processes by summarizing and putting in perspective certain GAAP and the federal securities laws as they relate to materiality. Armed with the guidelines of SAB no. 99 and skepticism about management’s motivation for meeting revenue expectations through aggressive reporting, the auditor can be alert to possible signs of fraud.

It’s no secret that battling financial fraud is a priority for the SEC. At the New York University Center of Law and Business on September 28, 1998, SEC Chairman Arthur Levitt put the accounting profession on notice that those who operate in the gray area between legitimacy and outright fraud are poisoning the reporting process. (See “Arthur Levitt Addresses ‘Illusions,’” JofA, Dec.98, page 12.) One of these illusions is earnings management, where, for example, financial reports reflect the desires of management—rather than the company’s underlying financial performance—in order to meet Wall Street’s earnings projections.

SEC RESPONSE

As a response to some of the concerns raised by Chairman Levitt, the SEC issued SAB no. 99 in August 1999. Although it does not really say anything new, the SAB synthesizes long-standing audit practices and addresses the application of materiality thresholds to the preparation and audit of financial statements filed with the SEC.

FASB defined materiality in Financial Accounting Concepts Statement no. 2, Qualitative Characteristics of Accounting Information: “The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”

SAB no. 99 contends that FASB’s definition is similar to the interpretation of materiality upheld by the courts under federal securities laws. The U.S. Supreme Court held that a fact is material if there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” (Basic, Inc. v. Levinson, 485 U.S. 224, 1988).

SAB no. 99 also offers examples of what is acceptable and what is not in regard to materiality.

Acceptable

Concept of materiality. Noting that the concept of materiality plays a vital role in the financial reporting process, the SAB cites the FASB Discussion Memorandum, Criteria for Determining Materiality: “If presentations of financial information are to be prepared economically on a timely basis and presented in a concise intelligible form, the concept of materiality is crucial.” It further states, “This SAB is not intended to require that misstatements arising from accounting close processes, such as a clerical error or an adjustment for a missed accounts payable invoice, always be corrected, even if the error is identified in the audit process and known to management.”

Assessing materiality as an initial step. Auditors’ reliance on quantitative thresholds, such as a materiality threshold of 5%, has become commonplace in the preparation and audit of financial statements. While use of these thresholds in assessing materiality is not objectionable, the point is that the threshold is not to be used as the justification for illegal activity.

Insignificant misstatements in normal course of business. Insignificant misstatements that result from the normal course of business rather than from an intentional scheme to manage earnings are acceptable. SAB no. 99 states, “Insignificant misstatements that arise from the operation of systems or recurring processes in the normal course of business generally will not cause a registrant’s books to be inaccurate ‘in reasonable detail.’”

Cost–benefit considerations. Registrants are not required to make major expenditures to correct small misstatements. As noted in SAB no. 99, “Thousands of dollars ordinarily should not be spent conserving hundreds.” In contrast, failing to correct misstatements when there is little cost or delay is unlikely to be “reasonable.”

Not Acceptable

Exclusive reliance on quantitative benchmarks. Registrants and the auditors of financial statements should not rely exclusively on quantitative benchmarks to determine whether items are material to the financial statements. They must consider both qualitative and quantitative factors in assessing the materiality of differences and/or omissions.

Intentional errors based on materiality. Intentional errors are not acceptable, regardless of materiality. Levitt addressed this issue when referring to companies that abuse materiality: “They intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter. If that’s the case, why do they work so hard to create these errors?”

Intentional misstatements violate federal law. Intentional misstatements are not acceptable under federal law. According to SAB no. 99, “Even if misstatements are immaterial, registrants must comply with Sections 13(b)(2) – (7) of the Securities Exchange Act of 1934. Rule 13b2-1 says, ‘No person shall, directly or indirectly, falsify or cause to be falsified, any book, record or account subject to Section 13(b)(2) (A) of the Securities Exchange Act.’”

Earnings management. Misstatements created with the intent of managing earnings are not acceptable, regardless of materiality. Accordingly, “It is unlikely that it is ever ‘reasonable’ for registrants to record misstatements or not to correct known misstatements—even immaterial ones—as part of an ongoing effort directed by or known to senior management for the purposes of ‘managing’ earnings.”

Offsetting misstatements. Registrants and their auditors should consider each misstatement and its materiality separately and in the aggregate. The aggregate effect of multiple misstatements cannot be justified by offsetting material misstatements with immaterial ones.

Quantitatively small misstatements. Qualitative factors may cause small amounts to become material. The SAB illustrates a number of qualitative factors that management and auditors might consider when evaluating the materiality of misstatements. In a financial statement, a quantitatively small misstatement may become material if the misstatement

• Arises from an item capable of precise measurement.

• Arises from an estimate and, if so, the degree of imprecision inherent in the estimate.

• Masks a change in earnings or other trends.

• Hides a failure to meet analysts’ consensus expectations for the enterprise.

• Changes a loss into income or vice versa.

• Concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability.

• Affects the registrant’s compliance with regulatory requirements.

• Affects the registrant’s compliance with loan covenants or other contractual requirements.

• Has the effect of increasing management’s compensation—for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.

• Involves concealment of an unlawful transaction.

The above list is not exhaustive. For example, consider potential market reaction to disclosure of a misstatement. If investor reaction to a quantitatively small misstatement significantly affects the share price of a stock, then the misstatement is material.

IN THE HEADLINES

Examples of materiality misapplications receive considerable attention in the financial press. Much of the publicity about immaterial misapplications of accounting principles started with the federal suit filed by the SEC in December 1998 against W. R. Grace & Co.

Grace had devised a plan to smooth earnings in its National Medical Care Inc. unit so that reported earnings would not miss Wall Street’s quarterly earnings target. In periods of strong earnings, Grace would report earnings that met the unit’s growth target and would hide what wasn’t needed in a reserve account. Grace then used the “cookie jar reserve” account to prop up earnings in lean periods. The company’s auditor identified these reserve profits in a 1991 memo. At that time, the reserves were expected to reach $23 million by the end of the year. The auditors proposed a reversal of the reserves. After Grace’s management had rejected the proposal, the auditors applied a liberal materiality standard to justify management’s decision and rendered Grace a clean opinion.

Is there too much auditor tolerance for intentional misstatements made by management to manage earnings? Financial fraud may begin with a minor breach of rules such as stretching out depreciation or recognizing revenues when the earnings process is not complete. Without realizing it, a company can step over the line as Waste Management, Inc., did with its depreciation schedules and level of environmental reserves, or as McKesson HBOC Inc. did when it recognized revenues from software packages that weren’t fully developed. Auditors’ vigilance can prevent minor breaches from slipping into material misstatements of profit.

MAKING THE RIGHT CHOICES

There’s nothing funny about relying on financial reports whose earnings have been managed. While there can be no absolute formulas in judging materiality, SAB no. 99 synthesizes the ground rules for auditors to measure transactions and events in financial statements. Consider that the auditor has identified a false statement about an immaterial item. Is management manipulating earnings or simply allowing an immateriality to pass? Given the relative ease to correct most misstatements, management’s refusal to make corrections can be symptomatic of a problem. Furthermore, intentions to make immaterial misrepresentations can be a short step to material misrepresentations.

Auditors’ choices have economic consequences beyond the immediate self-interests of the company and its management. The proper application of materiality should be a device to strengthen financial reporting and audit effectiveness, a device used from the perspective of auditor integrity.

For more information on SAB no. 99 and additional references on evaluating materiality, see www.aicpa.org/members/div/auditstd/opinion/oct99_1.htm.